Surname 4
To: Management of Justified Wages
From: [Insert Student Name]
Date:
Re: Accounting Treatment for “Repurchasing Own Shares at a Premium”
Background
Justified Wages, Inc. is a private company selling cloud software platforms for Internet of Things (IoT). The company helps product businesses to be IoT service providers and other firms to establish, oversee, and monetize the implementation of IoT globally. In November 2012, Well-to-Do, Inc. (WTD), an independent company, invested $40 million in Justified Wages by purchasing $30 million of Series E Proffered Stock and $10 million of common stock of Justified Wages (“Case 17-8”). The two purchases were completed and recorded as a single transaction.
With the new financing terms, the firm tendered to acquire the common stock share worth $10 million held by the employees at $4.68 per share, after which it sold the repurchased shares to WTD for similar value, $10 million. However, based on valuation by a third party, it was concluded that the amount paid to repurchase the common stock from employees was more than the fair value by $2.6 million (“Case 17-8”). Following the IFRS provision, the Justified Wages Inc. recorded a debit to the expense and treasury accounts as $2.6 (to show the excess amount paid over the fair value) and $7.4 million (to show the fair value of the common stock purchased) respectively and credited the cash account (“Case 17-8”).
Issues
1. Should the $10 million paid to employees and the $10 million received from WTD be presented gross or net in the company’s statement of cash flows?
2. How should the company classify the cash received and paid in its statement of cash flows?
3. Does the accounting analysis or conclusion change for each of the questions above when analyzed in accordance with IFRSs?
Analysis
Issue 1. The investing activities section of the statement of cash flow records gains or losses incurred from transactions in the financial markets. To arrive at such values, an in-depth analysis of the purchase or disposal of the financial asset is required (van Greuning et al. 23). To understand the various transactions involved in the repurchase of the common stock, records of the various accounts affected will be used. In repurchasing the common stock from employees, the company made an investment activity because it could gain or lose from the transaction. On the other hand, the money received from WTD to purchase common stock worth $10 million should be treated as a financing activity. To record the issuance of common stock by Justified Wages to WTD, the cashbook should be debited with the par value of the shares issued and the common stock account credited with the shares issued.
Dr. Cash book / $7.4 millionCr. The common stock account ($3.46 per share) / $7.4 million
On the other hand, the repurchase of the shares from the employees at a premium should be recorded on both cashbook and the common stock account as:
Dr. The common stock account ($3.46 per share) / $10 millionCr. Cashbook
with / $10 million
The journal information above should be recorded in the statement of cash flows as shown below:
Justified Wages, Inc.
Statement of Cash flows
Cash from Investing Activities
Issuance of common stock to staff / $7.4 millionRepurchase of common stock / ($10 million)
Issuance of common stock (WTD) / $10 million
Net cash provided by investing activities / $7.4 million
Workings:
To obtain the cost per share for the shares sold to employees
10 million/4.68 =2136752.14 shares
7.4 million/2136752.14 shares = $3.46 per share
As apparent, Justified Wages incurred a loss of $2.6 million during the repurchase of the common stocks from its employees. The amount paid to the company’s workers in reacquiring the common stock share for resale to WTD is recorded as a net cash in the statement of cash flows, under the section of cash from investing activities, to reflect the changes in the company’s cash from the common stock transactions. ASU 2016-18 states that
“(..) entities must show the changes in the total of cash, cash equivalents, restricted cash and restricted cash equivalents in the statement of cash flows (...)”
This recording is a requirement that the company can ascertain and recognize gains and losses due to investments for the purposes of reporting and taxation (Subramanyam 56). As provided by the IFRS, this net case from investments is a liability incurred during the repurchase of a financial asset. The value of this liability does not exceed the par value of the asset in question; therefore, it should be charged to the equity account as follows:
Cr. Cashbook / $10 millionDr. The common stock account / $2.6 million
Dr. profit and loss account / $ 2.6 million
To record the amount received from WTD to finance Justified Wages., the cash amount of $10 million should be debited in the cashbook and the common stock account should be credited with $10 million for the purchase of the shares from employee ($4.68 per share).
Dr. Cash book / $10 millionCr. The common stock account ($4.68 per share) / $10 million
The transaction should be recorded as a financing activity in the statement of cash flows
Justified Wages Inc.
Statement of Cash flows
Cash from Financing Activities
Issuance of common to WTD / $10 millionGross cash provided by Financing activities / $10 million
According to the provisions of the International Financial Reporting Standards, IFRS 7, cash flows from investing activities should be recorded as a gross amount. The total figure captured in this section is gross amount because the gains have not been recognized; it is the amount received from the investor in the purchase of shares from Justified Wages Inc.
Issue 2.
AC 230-10-45-4 describes what a statement of cash flows should report.
“(…) a statement of cash flows shall explain the change during the period in cash and cash equivalents (..)”.
The gain or loss incurred during the purchase or sale of a financial asset is recorded under the cash from investing activities, which affects cash flows according to AC 230-10-45-4 (Cox 34). This value is used to determine the tax burden and net cash from the investing activities. The cash received from WTD in the purchase of ordinary and preference shares should be recorded under cash from investing activities as follows:
Justified Wages, Inc.
Statement of Cash flows
Cash from financing activities
Issuance of common stock to WTD / $10 millionIssuance of prefered shares to WTD / $20 million
Gross cash provided by Financing activities / $30 million
The cash paid to Justified Wages employees to repurchase the common stock sold to WTD should be recorded under cash from investing activities as follows:
Justified Wages, Inc.
Statement of Cash flows
Cash from investing activities
Repurchase of common stock / $10 millionGain/Loss from repurchase / ($2.6 million)
Issuance of common stock / $10 million
Net cash from investing activities / ($2.6 million)
Issue 3. Apparently, the conclusions from the two issues discussed above changes when assessed according to ASC 230-2-26 because of the different accounting regulations used in the preparation of the statement of cashflows.
“(…) cash flows from purchases, sales, and maturities of available-for-sale securities shall be classified as cash flows from investing activities and reported gross in the statement of cash flows (..)”
In line with ASC 230-2-26, the cash from investing activities is a net of $7.4 million, representing the total cash obtained by the company after repurchasing the common stock from its employees. However, issue two reveals a loss of $2.6 million in the cash flows from investing activities. This difference is observed because issue one has focused on a single transaction involving the repurchase of the shares from its employees. In issue one, the cash is still in the company’s cash account, making it available for financing the company’s operations. Conversely, issue two recognizes the loss incurred when the shares were repurchased and sold. The overall effect on the company’s cashflows from investing activities, therefore, is a loss (Wahlen et al. 126).
Conclusion
The above case brings out two issues provided by the Generally Accepted Accounting Principles (GAAP) and the International Financial Reporting Standards (IFRS). IFRS 7 requires entities to disclose all material information about the statement of cash flows to enable the users of the financial statement gauge the changes in liabilities resulting from financing activities. First, the issue of repurchasing a financial asset is considered an investment activity whose gain or loss should be reported to the statement of cash flows. The ASC 230-2-26 further provide how to record a gain or loss exceeding the par value of the asset in question. In this case, there was a loss of $2.6 million incurred by Justified Wages due to the repurchase of common stock at a premium from its employees. Since this loss does not exceed the par value, it was recognized under the equity account. Secondly, the manner in which the transaction is recorded determines the values presented in the published statement. When an activity involving multiple transactions is regarded as one transaction, the entries made in the books differ from the case where each transaction is recorded separately. Therefore, companies are required to make financial statements in accordance with the provided guidelines, stating the accounting policies and other material information relevant to the statements in the notes section.
Peer company analysis
In a similar case study of Oracle's 2004-2007, the company decided to buy back it stock from the staff. At the time of purchase, a third party was involved to value and purchase the shares. Similar to Justified Wages, the shares were overvalued, resulting in a loss to the company. Consequently, the employees benefited for the overvaluation as they made an eight percent profit (Gumport 2). The overvaluation did not exceed the par value of the shares; therefore, the entries were made like those made in the above case of Justified Wages.
Impact on financial statements
ASC 230-2-26 describes the various investing activities.
“9(…) investing activities include making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, and equipment and other productive assets, that is, assets held for or used in the production of goods or services by the entity (other than materials that are part of the entity's inventory) (…)”
Therefore, the investing activities have an effect on various general purpose financial statements. As evident from the above discussion, the paper has effectively completed the relevant journal entries recording the transactions. The various transactions involved in the repurchase and resale of the shares to WTD should be recorded as follows:
Dr. Cash book / $7.4 millionCr. The common stock account ($3.46 per share) / $7.4 million
Impact on financial statements
The above transaction is an investing activity that should be recorded ass follows:
Justified Wages, Inc.
Statement of Cash flows
Cash from Investing Activities
Issuance of common stock to staff / $7.4 millionRepurchase of common stock / ($10 million)
Issuance of common stock (WTD) / $10 million
Net cash provided by investing activities / $7.4 million
To record the amount received from WTD to finance Justified Wages
Dr. Cash book / $10 millionCr. The common stock account ($4.68 per share) / $10 million
Effect on the statement of cash flows
Justified Wages Inc.
Statement of Cash flows
Cash from Financing Activities
Issuance of common to WTD / $10 millionGross cash provided by Financing activities / $10 million
To record the cash received from WTD in the purchase of ordinary and preference shares
Statement of Cash flows
Cash from financing activities
Issuance of common stock to WTD / $10 millionIssuance of prefered shares to WTD / $20 million
Gross cash provided by Financing activities / $30 million
Works Cited
Case 17-8: Justified Wages. Deloitte Development LLC, 2016, www2.deloitte.com/content/dam/Deloitte/us/Documents/about-deloitte/trueblood/us-dfdtn-17-8-case-justified-wages.pdf. Accessed 30 Oct. 2017.
Cox, David. Financial Statements. Osborne Books Limited, 2013.
Gumport, A. M. Analyzing Stock Buyback Board Decisions (#4) - Oracle Case Study. 2009.
Subramanyam, K. R.Financial Statement Analysis. 11th ed., McGraw-Hill Education, 2015.
van Greuning Hennie, et al.International Financial Reporting Standards: A Practical Guide. 6th ed., The World Bank, 2011.
Wahlen, James M, et al.Intermediate Accounting: Reporting and Analysis. 2nd ed., Cengage Learning, 2017.